By Frances Coppola
There is more than one “spot” rate a business or FX trader may need to know. For example, FX traders make money on the spread between the rate at which they will buy and the rate at which they will sell currencies: these are known as the “bid” and “offer” rates, respectively. However, the “exchange rate” for a currency pair usually refers to the “mid” rate, which is the midpoint between bid and offer. The exchange rate on a spot FX transaction will typically be higher or lower than the mid rate, depending on whether it is struck at the bid or offer rate.
While large players in the interbank FX market have the clout to negotiate and influence market bid and offer rates through trading activity, smaller players are more likely to be price takers. For example, businesses and individuals obtaining FX through an intermediary such as a bank or broker may find their quoted spread between bid and offer rates is wider than the market spread. However, FX platforms may help businesses get better FX spot rates by timing their trades to take advantage of transient differences in bid and offer rates between different FX service providers.
The term “spot” in relation to an FX transaction means “on the spot.” Colloquially, the term means having to come up with something straight away. But in FX markets, “on the spot” means “on the settlement date.” This means traders do not need enough currency to settle a spot FX transaction as soon as it is struck. The “settlement” or “value” date is the date on which the funds are physically exchanged, and usually occurs two business days later than the transaction or “trade” date. Conventionally this is expressed as T+2.
Some currency pairs may settle earlier. For example, the settlement date for USD-CAD (Canadian dollar) and USD-TRY (Turkish lira) is one business day later than the transaction date, or T+1. The Chinese yuan and Russian ruble can both settle on the trade date, or T+0 (though T+1 settlement is more usual). “Business days” exclude Saturdays, Sundays, and legal holidays in either currency of the traded pair. Thus, during the Christmas and Easter seasons, some spot trades can take as long as six days to settle.1
Since in both spot and forward contracts settlement occurs some time after the trade is agreed, it could be argued that all FX contracts are effectively forward. However, there are significant differences between contracts deemed “spot” and those that are “forward.”
The settlement date of a forward contract is its expiry or “maturity” date. If the forward contract is deliverable, the parties physically exchange funds on that date. But a spot contract has no expiry date. The trade “matures” when it is struck, and the later delivery of funds is simply a matter of market convention.
The two types of contract are priced differently, too. On a spot contract, the exchange rate is simply the market rate on the trade date for that currency pair. In contrast, the exchange rate on a forward contract is typically based on a formula that factors in interest rate differences. The principle of “covered interest parity” enables the forward exchange rate for a currency pair to be calculated as a function of the spot exchange rate and the interest rates in both countries. In plain English, the forward rate is equal to the spot rate multiplied by the quotient of one plus the domestic interest rate over one plus the foreign interest rate, or:
However, this formula must be adjusted to account for the length of the contract. For example, consider a 3-month forward contract to exchange $10,000 for Canadian dollars when the current exchange rate is USD 0.75. The U.S. base interest rate (Fed Funds Rate) is 2.5 percent, and the Canadian base rate is 1.75 percent. The “day basis” (the number of days in a year for the purposes of interest calculation) is 360. Calculating the exchange rate on the forward contract would look like this (with rounding):
The small interest rate difference between the two countries gives the U.S. dollar a “forward premium. “This is typically quoted as a number of “points.” One point represents 1/10,000, so in the example above, the forward premium is 0.006, or 60 points over three months.2
No such calculation is done for a physically settled spot contract, even though the spot rate may have moved by the time the contract settles.
Although spot FX trades always have a settlement date, most are not physically settled. Traders typically want to profit from exchange rate differences on their transactions, rather than acquiring large quantities of currency. So, many traders simply “roll over” transactions on the settlement date. They close off the transaction at the closing price and re-open it at the next day’s opening price, in effect extending the settlement date by one day. The difference between the closing and opening prices is taken as profit or loss. Many brokers do this automatically for their business and individual customers.3
Simultaneously entering into buy and sell trades with settlement one day apart is a type of FX swap widely used to roll over positions. It is known as “tomorrow next” or “tom-next.” Although the two trades involved are spot trades, the swap price is calculated using interest rate differences in the same way as for a forward contract.4
FX forward contracts are an alternative to rolled-over spot contracts that may provide better protection against sudden currency movements. However, businesses looking to profit from FX movements may prefer an active FX management strategy involving spot FX contracts and swaps.
The spot FX market is complex, and the distinction between spot trades, forward contracts, and swaps can be unclear. For international businesses managing multiple currencies, the time-to-settlement in spot FX trades can be an important factor in cash flow and FX risk management, especially if the currency exchange rate is volatile.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Value dates,” London FX; http://www.londonfx.co.uk/valdates.html
2. “Calculating forward exchange rates – covered interest parity,” Riskprep; https://www.riskprep.com/all-tutorials/36-exam-22/59-calculating-forward-exchange-rates-covered-interest-parity
3. “What does rollover mean in the context of the FX market?,” Investopedia; https://www.investopedia.com/ask/answers/06/rollover.asp
4. “Tomorrow Next – Tom Next,” Investopedia; https://www.investopedia.com/terms/t/tomorrownext.asp